In a lengthy decision, the Tax Court recently underscored the difficulties taxpayers have in convincing the IRS that family-run farms are engaged in for profit. The case, Smith v. Commissioner, T.C. Memo 2007-368, ruled on two families’ limited partnerships, involving a cow and dairy farm, a cutting horse operation and dog breeding. The court held that the cow and dairy farm was engaged in for profit under the IRS hobby loss rules, but not the other activities. The taxpayers had taken significant tax deductions against their income from the activities, thus prompting an IRS audit, which they lost and then appealed to the Tax Court.
As discussed in the decision, the taxpayers sought a niche in the market in order to compete as to product and price, and decided to raise Normande cattle. A milking parlor with automatic milking equipment and other improvements were made, pastureland reclaimed and miles of fencing installed. The taxpayers had a formal 7-year business plan written by a professional that focused on importing of bull semen from France. After getting started they sought and obtained certification as an organic farm with a view towards selling milk at higher prices than conventional milk. They consulted with experts, maintained a separate checking account, and focused on ways to maximize revenue. Gross revenues exceeded $100,000 for some years, but there was still a net loss. The taxpayers said they expected to increase revenue due to the organic certification. They hired a full-time farm manager who, the court noted “did approach the operation of the cow activity in a businesslike manner,” although he did not keep many formal records. The manager lived on a trailer on the property, and the taxpayers retained decision-making authority.
Through study, the taxpayers gained expertise in the breeding of cows and in the use of Normande cows for dairy purposes. They spent an average of 20 to 30 hours per week on the cow and dairy farm activity, and the court said this was “significant.” The court allowed the tax deductions for the cow operation. The court noted with approval that the taxpayers, with regard to the cow operations, sought to reduce expenses, had a farm manager, spent a significant amount of time of their own on the farm, had a separate checking account, and focused on a competitive breed.
The horse activity, however, was another matter, and the court ruled that this was not conducted for profit. The taxpayers showed and bred cutting horses. There was no business plan and very little by way of books of the activity other than Schedules F on their tax returns. Oral testimony about the horse activity was “lacking in specifics.” The bank account used for the horse activity was the taxpayer’s personal checking account. There was no evidence to show the horses purchased or their progress and profitability. The court also ruled against the taxpayers on their dog breeding activity, for much of the same reasons as it denied the horse activity deductions. Dog breeding is governed by the same regulations under the IRS hobby loss rule.
In recent years the IRS has consistently denied tax deductions to farmers, ranchers and horse owners who do not have a formal business plan, and this Tax Court case confirms that policy. The taxpayers in this case in fact had a professionally drafted business plan for their cow operations, and the court allowed those deductions based primarily on that fact.
John Alan Cohan is a lawyer who has served the farming, livestock and horse industries since 1981.
